The pitfalls of an unbalanced portfolio
Being a fan of a losing sports team can be painful (Jets fans?). But as a sports fan, we don’t risk our financial future with continued support from the team. However, continue to support a portfolio of companies losing in the face of changing market dynamics can be a recipe for lasting underperformance.
There is no point in having a strong conviction in your stock choices, but to deceive them dramatically. Conviction should be a measure of the skill of the investment team and it is not measured by the number of stocks you own, but by the consistency and persistence of beating the benchmark.
Source: Internal investor
High conviction investment strategies sometimes call for the unwavering support of a portfolio of companies in the face of a change in market sentiment. High conviction strategies have the potential to performs incredibly well but can also lead to financial ruin if poorly timed or executed.
A potential negative effect of successful investing is the tendency to overestimate one’s skill level. This can cause the investor to push further on the risk spectrum where he is burned by a unexpected change in market appetite for risk.
The more successful you are at something, the more convinced you are that you are doing it well. The more convinced you are that you are doing it well, the less open you are to change. The less open you are to change, the more likely you are to stumble in a world that is constantly changing.
Source: Morgan housel
The best-performing strategy in one calendar year often performs remarkably poorly the following year. For example, the ETF Ark Innovation (ARKK).
Source: Morningstar ARKK Performance
ARKK was the best performing ETF in 2020 with an incredible return of 156.9%. Turn the page a year later though, and it was one of the worst performing ETFs with a -23.6% return for the year. This provides insight into the downsides of maintaining a high conviction strategy in the face of a changing market environment. 2022 hasn’t looked much better for ARKK as the fund is already down more than 10% since the start of the year.
A sure-fire way to underperform your benchmark is to focus the portfolio on losing positions. However, sometimes a high conviction investment can require a fair amount of profit taking. Ark selling his Tesla stock (TSLA) with the highest conviction was an example of prudent portfolio management.
Unfortunately, Ark decided to reinvest that money in more of its unprofitable growth companies, doubling down on a losing investment strategy. This has provided little of a safe haven in the risk-free market environment we find ourselves in. It can be difficult to remain convinced of your strategy, especially when faced with heavy losses. However, it will become even more difficult when the portfolio balance is actively ignored.
The value of maintaining realistic expectations
Hope itself should not be viewed as an investment strategy. Arbitrarily fall in love with stocks we own can be detrimental to our long-term returns. Selecting individual companies for investment requires a lot of commitment, but that doesn’t mean we need to increase our position size indiscriminately.
Hope is the belief in the possibility of a positive outcome, even though there is evidence to the contrary. Despite the lingering bad news, investors will steadfastly hold onto their losing stocks, on the sole basis of the faint hope that they will return at least to the buy price. The decision to hold is not based on rational analysis or a well thought out investment strategy, and, unfortunately, wishing and hoping that a stock will go up will not.
This is especially true for newly opened companies with potentially unproven business models. Stock indices don’t always go up, so it’s helpful for investors to have a strategy to protect themselves against a downside. Maintaining a strong conviction in our investments is important, but it does not improve our chances of success in any way.
In the late 1990s, fueled by the potential of the internet, hundreds of small businesses sprang up, determined to disrupt and profit from industries. A decade later, almost all of them were gone. Many of the famous failures – Pets.com (pet supplies), Boo.com (fashion), and Beenz (digital currency) – now appear to be a bit ahead of their time, as many of their products have become hits. in the modern world.
Source: Harvard Business School
Investors cite examples of companies taking losses that eventually recovered as an excuse to focus a portfolio on companies that were losing money. Amazon, (AMZN) one of the most frequently cited examples, is the exception rather than a rule by which we should live.
According to a JP Morgan study, 40% of all stocks experience catastrophic decline from which they never recover.
Source: Michael batnick
One problem with focusing on these types of examples is that they are very unlikely to occur, especially at a level of magnitude that Amazon has been able to reach. Winning companies will eventually recover, rewarding their investors for maintaining their conviction, but a significant portion of companies will never return to their former highs.
Choosing the wrong stock during a period of marked underperformance has been a proven recipe for poor long-term returns. Ironically, this idea was shared in March 2020; one of the most ideal times to use a catchy investing strategy.
Predicting the direction of the short-term stock markets is clearly a difficult task. However, if one chooses to maintain a high conviction investment strategy, it is best to ensure that you choose the right companies to invest in during times of market turmoil.
Stock markets go up, but can sometimes take decades to reach new highs
In the long term, the stock markets move in one direction, upwards. There are, however, times of market weakness that will test an investor’s conviction. So I think it’s helpful for investors to have a game plan when a preferred investment strategy is no longer in fashion.
Using a balanced portfolio with a combination of performing assets in all market environments will help you stay the course. Belief is always important to invest, but without sufficient balance in the portfolio, concentrated investment strategies will become more difficult to implement.
The reality is that only a small subset of stocks will generate the majority of a stock market’s earnings. This is the reason why index investing has become such a popular strategy over the years. If you choose to focus your portfolio on just a small subset of actions, they must be prepared for the wide range of results that can result.
With 40% of stocks failing catastrophically, it’s inevitable that investors will pick losing stocks at some point. Learning to dispose of your losing positions is a precious tool for investors. Experiencing losses in a portfolio often provides excellent feedback that can improve its investment strategy. Fighting our inherent biases and reducing losing positions can be a tough pill to swallow, but it’s an attribute shared by many. the biggest investors in the world.
The stock markets have a knack for humiliating us when we least expect it. By focusing a portfolio on losing positions, our long-term returns may suffer. Maintaining conviction in one’s actions can be a difficult task, especially in the face of heavy losses. A commitment to keeping your portfolio balanced will make this task less daunting.